When a borrower defaults under its credit facility and begins to slide into insolvency, certain actions by its secured lender can become scrutinized. A secured lender who continues to lend to a borrower under such financially distressed circumstances can become subject to costly and unnecessary claims by the unsecured creditors of such borrower under a theory called “deepening insolvency.”
The theory is that as the borrower drifts into insolvency there is a point where the lender, by lending or continuing to lend, to the borrower is participating in the deepening insolvency of the borrower. The theory suggests that the lender knows that there is little hope that the borrower can repay all of its obligations to all of its creditors, but such lender is protected by being secured by the assets of the borrower. However, unsecured creditors of the borrower who continue to do business with the borrower rely on the fact that the lender lends or continues to lend funds to the borrower and the unsecured creditors are harmed as a result.
While this theory has been rejected by most courts, the theory (or variants of it) is still argued in some bankruptcy proceedings and, in those instances, a lender must waste valuable time and resources to defend itself from such claims. However, a lender can limit its exposure to such claims and the cost of defending itself by clearly signaling the nature and scope of the borrower’s financial distress to outside parties, including the unsecured creditors. The lender can do so by entering into a forbearance agreement with the borrower, instead of a waiver and amendment, as described below. But first, a cautionary tale to illustrate the risks a lender may face by taking the wrong course of action.
A lender entered into a senior secured credit facility with a borrower in which a financial covenant that was designed to test the borrower’s liquidity was breached. The lender sent the borrower a reservation of rights letter and the lender and borrower proceeded to analyze the borrower’s business and financial situation. Both the lender and borrower agreed that the borrower’s business as currently conducted was not viable, and that the borrower needed to raise significant capital to improve its liquidity or needed to sell the business as a going concern, or, if unsuccessful in those efforts, must then contemplate liquidation. The lender and borrower began the process of negotiating a forbearance agreement that included detailed milestones for a capital raise or sale of the business, and also included simultaneous milestones designed to prepare the borrower for bankruptcy in the event that the equity raise or sale was unsuccessful.
At the same time, the borrower was also engaged in discussions with its critical vendors, attempting to persuade them to continue to ship goods to the borrower on ordinary terms, even though the borrower was stretching its account payables. The borrower also requested that, in order to improve the borrower’s liquidity, the critical vendors agree to enter into agreements to convert certain outstanding trade payables to junior secured subordinated term debt.
After the terms of the forbearance agreement were all but final, the borrower requested that the lender style the lender/borrower agreement as a waiver and amendment instead of as a forbearance agreement. The borrower argued that such a change would improve the optics of the situation and would assist the borrower in persuading its critical vendors to both continue to ship goods on ordinary terms and to agree to the conversion of the trade payables plan. The lender was focused on the borrower’s need to raise significant capital or sell the business and simultaneously prepare for a bankruptcy filing. Further, the lender did not view the business deal as changing whether the document was styled as a forbearance agreement or as a waiver and amendment. The lender did not think about the critical vendors’ difference in perception between styling the document as a forbearance agreement or as a waiver and amendment, and so it agreed to the borrower’s request.
The waiver and amendment was entered into by the lender and borrower. The borrower was successful in persuading its critical vendors to continue to ship goods on ordinary terms and to convert trade payables into junior secured subordinated term debt. However, the borrower was unsuccessful in its efforts to raise capital or sell the business, and subsequently proceeded to file for bankruptcy. The borrower’s assets were ultimately liquidated in the bankruptcy.
Claim Against Lender
The critical vendors sued the borrower’s management for fraud and related claims, and also sued the lender for aiding and abetting such fraud. The critical vendors’ claim against the borrower’s management was that the terms of the agreement between the lender and borrower had been misrepresented, and that, in reliance on such misrepresentations, the critical vendors shipped goods to a company that was on the verge of filing for bankruptcy without taking any additional actions to protect themselves. The critical vendors’ claim against the lender was that it knowingly aided and abetted the fraud of the borrower’s management in order to facilitate the shipping of additional goods to the borrower, which goods were then liquidated and the proceeds used to pay off the lender’s senior secured claim. Although the critical vendors claim was technically aiding and abetting fraud, such claim was principally based on the deepening insolvency theory.
In fact, the lender had no nefarious intent, and the lender’s debt was fully collateralized by the existing assets of the borrower’s business before any additional goods were shipped by the critical vendors. The lender believed it was giving the borrower one last shot to turn the business around or to sell the business, but also believed it was protecting itself if such attempt was unsuccessful. The lender was not present when the borrower’s management held a meeting with the critical vendors, and was not privy to what the borrower’s management communicated to the critical vendors about the agreement between the lender and borrower. The lender had no duty to the critical vendors, as they were fully able to protect themselves had they demanded to know and understand the terms of the agreement between the lender and borrower, or modifying their payment terms so as to limit future exposure, using credit insurance or other means. The lender’s view was that the critical vendors made a calculated gamble by continuing to supply goods on ordinary terms to an important customer in financial distress in the hopes that the customer would survive and subsequently buy additional goods from them in the future. The lender should ultimately be successful in defending itself against these vendor claims as they are based upon the deepening insolvency theory. However, the lender might have avoided the cost and expense of defending itself if it had considered the perceptual difference to the other creditors of the borrower of a forbearance agreement versus a waiver and amendment.
Course of Action after Default
After a default under a credit facility, a lender typically notifies the borrower that a default has occurred and, in connection with such notice, reserves its rights under the loan documents and applicable law. After the delivery of the reservation of rights letter, the lender analyzes the reasons for the default; if the default indicates a negative business trend or other issues, the lender will then analyze the borrower’s business and its financial situation. Depending on the lender’s analysis, and after discussions with the borrower’s management, the lender will decide on one of the following courses of action: (i) waive the specified defaults and amend the terms of the credit facility, (ii) agree to forbear from exercising its rights and remedies for a limited period of time, or (iii) exercise its rights and remedies. While the exercise of rights and remedies after a default under a credit facility might be warranted in certain situations, a lender most often decides to either waive the default and amend the terms of the credit facility pursuant to the terms of a waiver and amendment, or to forbear from exercising its rights and remedies pursuant to the terms of a forbearance agreement.
Reasons that a Lender Does Not Immediately Exercise Rights and Remedies
The reasons vary that a lender chooses to enter into a waiver and amendment or a forbearance agreement instead of immediately exercising its rights and remedies, but among such reasons are the following: (i) to allow the borrower additional time to address business and/or operational issues and to try to turn around its business, (ii) to allow the borrower additional time to raise junior capital and/or refinance the credit facility, (iii) to allow the lender and borrower additional time to work out a consensual restructuring and/or allow the borrower additional time to prepare for a bankruptcy filing, and (iv) to shield the lender from lender liability issues.
Legal and Perceptual Difference Between a Forbearance Agreement and Waiver and Amendment
A forbearance agreement and a waiver and amendment contain similar provisions but there is a legal difference between these two types of agreements. A forbearance agreement does not eliminate a default but rather expressly preserves the default, with the lender agreeing only to refrain from exercising its rights and remedies for a limited period of time. On the other hand, a waiver and amendment waives the default, and is an agreement by the lender to not exercise its rights and remedies in respect of the specified defaults and, subject to the amendments contained therein, to restore the borrower to its pre-default status.
Regardless of this legal difference, the two types of agreements can be viewed on a continuum, with a waiver of a one-time default of a less substantive matter reflecting minimal distress in the borrower’s business (i.e. “a foot fault or technical default”) to a forbearance agreement with a short forbearance period and onerous milestones reflecting greater distress in the borrower’s business (i.e. “last chance to turn the business around”). To outside parties, and in particular to the other creditors of the borrower, a forbearance agreement provides a stronger signal of the borrower’s distress than does a waiver and amendment.
Forbearance Agreement or Waiver and Amendment
Notwithstanding the differences between a forbearance agreement and a waiver and amendment, a lender and borrower could negotiate the terms of an agreement addressing specified defaults and other important issues going forward in the borrower’s business, and could decide to style the document either as a forbearance agreement or a waiver and amendment. To the lender and borrower, the business deal would be the same.
However, when deciding which type of document to use, the lender needs to think about the message that a forbearance agreement sends to the other creditors of the borrower versus a waiver and amendment. If the lender believes the viability of the borrower’s business is at stake, and intends to exercise rights and remedies if certain milestones are not satisfied, then using a forbearance agreement as opposed to a waiver and amendment is the better alternative. The lender’s use of a forbearance agreement will signal the nature and scope of the borrower’s financial distress to the borrower’s other creditors and will prevent the lender from being subject to claims by such other creditors if the borrower should ultimately fail to survive.
Timothy P. Manning, Counsel at the Boston area law firm Morse Barnes-Brown Pendleton, concentrates his practice in the area of debt finance representing banks, commercial finance companies and alternative lenders in various commercial loan transactions.